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How to Make the Best Choice of Entity to Lessen Your Tax Burden

When determining what entity type is best for your organization, you need to consider several factors, and working with an outside adviser can help avoid trouble down the road.

A limited liability company (LLC) often makes the most sense, as it provides the most flexibility, but there are other options to consider. Even with an LLC, you need to determine the best way to be taxed.

What types of entity structures can businesses choose from?

The most common options are a C corporation, an S corporation, partnerships and, as mentioned above, an LLC.

A corporation (S or C) is a separate legal entity. C corporations are tax paying entities, that is, they pay taxes on their taxable income just as individuals pay taxes on their taxable income. A C corporation can make a distribution to its shareholders, which may be taxed as a dividend. These dividends are not deductible to the corporation, but taxed, at least until 2013, at a favorable tax rate to the recipient. Depending on the tax situation of the individual and the corporation, paying some dividends may result in less taxes paid by the corporation and individual combined.

An S corporation is also a separate legal entity but generally is not a tax-paying entity for federal tax purposes. An advantage of an S corp. is that its profits are taxed to the shareholders, not the corporation itself; therefore the double taxation that exists in a C corp. is eliminated. Another advantage is that the amount of profits taxed to the shareholders is subject to self-employment tax. Since S corp. profits are not subject to self-employment tax, you can manage your self-employment taxes better than in a C corp. In an S corp., profits and losses have to be allocated to the shareholders in the same percentages, as ownership and distributions cannot be disproportionate.

Another entity structure option is an LLC. Generally, a multi-member LLC will be taxed as a partnership. An LLC filing a partnership return is not a tax-paying entity and the profits and losses flow through to the members in a similar manner to an S corp. Members of an LLC can elect to have the entity taxed as a S. corp or a C. corp.